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The Cost of Bitcoin

Putting aside the particulars of Bitcoin, the potential it represents is absolutely a very big deal.

As I’ve written multiple times on stratechery, the defining characteristic of anything digital is its zero marginal cost. Take apps for example:

What makes the software market so fascinating from an economic perspective is that the marginal cost of software is $0. After all, software is simply bits on a drive, replicated at the blink of an eye. Again, it doesn’t matter how much effort was needed to create said software; that’s a sunk cost. All that matters is how much it costs to make one more copy – $0.

The implication for apps is clear: any undifferentiated software product, such as your garden variety app, will inevitably be free. This is why the market for paid apps has largely evaporated. Over time substitutes have entered the market at ever lower prices, ultimately landing at their marginal cost of production – $0.

The same story applies for music, movies, content, etc., and this has fundamentally changed what it means to do business on the Internet. It’s why, for example, WhatsApp was so valuable to Facebook: attention is the true finite resource, and how it’s commanded is, in some ways, besides the point.

Bitcoin and the breakthrough it represents, broadly speaking, changes all that. For the first time something can be both digital and unique, without any real world representation. The particulars of Bitcoin and its hotly-debated value as a currency I think cloud this fact for many observers; the breakthrough I’m talking about in fact has nothing to do with currency, and could in theory be applied to all kinds of objects that can’t be duplicated, from stock certificates to property deeds to wills and more.

What makes Bitcoin so clever is how it assumes self-interest and uses incentives. To put it in the simplest possible terms, instead of a paid broker for transactions, tens of thousands of distributed computers working independently do the verification, at no cost to those involved in the transaction. Their reward is the possibility of more Bitcoin – the verification process is also the mining process. Most people are focused on the “mining” part of the process, but it’s the verification aspect that is profound.

Unfortunately, it’s not clear you can really divorce this verification process from the speculation involved with mining; it’s the speculation that incentivizes the verification. In other words, while the process behind Bitcoin enables unique digital goods beyond currency, the incentives only really work if said digital good has stored monetary value. Absent those incentives those doing the verification would need to earn some sort of commission, and then we’re right back where we started.1

Still though, currency is something – surely no-fee transfers is worth celebrating! And, as someone who regularly deals with wire transfers, I’m sympathetic to this point. Still, even if zero-fee transfers became seamless, Bitcoin as presently architected would be anything but free, and every one of us would have to pay the price.

In economics, an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.

For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society, whereas the neighbors of an individual who chooses to fire-proof his home may benefit from a reduced risk of a fire spreading to their own houses. If external costs exist, such as pollution, the producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs. If there are external benefits, such as in public safety, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved. Thus, it is said that, for goods with externalities, unregulated market prices do not reflect the full social costs or benefit of the transaction.

Recall the magic that makes Bitcoin profound: scores of independent computers all over the world running at full speed in the hope of capturing new Bitcoin, and in the process verifying transactions for free. Those computers need power, and that power needs to be generated. True, whoever owns the servers is paying a huge electricity bill, but (in most areas of the world) that electricity bill does not include the societal cost of pollution generated by electricity production.2

Moreover, the design of Bitcoin guarantees that electrical consumption increases dramatically indefinitely. Normally, you would expect the supply of computing power for a digital currency to initially increase, thus increasing the supply of said digital currency, which then lowers the price, ultimately reducing demand:

Under normal conditions, as the supply of computing power increases, the amount of a digital currency would increase as well. This lowers the price, eventually reducing demand.

That’s not the case with Bitcoin though. Anticipating the amount of power that would be thrown at mining Bitcoin, Satashi Nakamoto built in a simple escalator that ensured new Bitcoin would be released about every 10 minutes no matter the amount of power being applied to mining/verification. This has effectively locked Bitcoin miners into a zero sum contest wherein greater and greater computing power serves only to steal opportunity from fellow miners; there is no corresponding increase in Bitcoin to be had.

Bitcoin is designed to be released on a regular schedule, no matter how much computing power is applied to it. This means supply will never catch up to demand, resulting in ever higher prices paid for with more computing power, i.e. more electricity.

The only possible increase is in computing power, which ultimately means Bitcoin effectively uses electricity as a release valve for inflation, compounding the externalities that accompany power production.

For what it’s worth, the structure of Bitcoin dictates that the price continue to rise, presuming it remains a viable currency. That price, though, is not free, and no one asked me if I were willing to pay.

In fact, Bitcoin, which has a cap on the total amount of Bitcoin that will ever exist, is ultimately headed this way [↩]

For the record, I am a major proponent of carbon taxes as both a means of reducing pollution as well as spurring innovation [↩]